The central bank has the sole authority to issue money (currency) and the responsibility to regulate the banking system in order to secure the value of money and realize the other objectives of monetary policy. Money serves as the medium of exchange and the commonly accepted means of payment, and as such as a measure of value. Excessive fluctuations in the value of money lead to economic distortions and causes social inequities. Inflation gives windfall gains to the rich and the business people but causes hardship to the fixed and low-income groups by eroding their purchasing power. Worse still, deflation often deprives the latter of their employment and means of livelihood. The phenomena of inflation and deflation are characteristic of the financial system based on the institution of interest, which is prohibited in Islam.

Consistent with the Islamic ideals of social justice, equity, fairness and balance, there are three major objectives of monetary policy in an Islamic economy, which discards interest. These objectives are:

1. Stability in the value of money;
2. Economic well-being with full employment and optimum rate of economic growth; and
3. Distributive justice.

For a proper appreciation of the above-mentioned objectives of monetary policy and how these may be realized, they are explained below.

Stability in the Value of Money
In an Islamic economy it is almost mandatory on the central bank to preserve the value of money. Thus the central bank should allow expansion of money supply to the extent it is justified by a possible contribution to growth in real balances. The stability in the value of money should be accorded high priority because of the unequivocal stress of Islam on honesty and fairness in all human dealings, and because of the negative impact of inflation on socio-economic justice and general welfare. But, rather than absolute, this objective would mean relative stability in the general price level. Absolute price stability is neither feasible nor desirable as it may conflict with the optimum growth and full employment objective of the monetary policy.

Economic Growth and Employment
While inflation is incompatible with the goals of an Islamic economy, prolonged recession and unemployment that cause human sufferings are also unacceptable. Monetary policy has, therefore, to aim at a high rate of economic growth with full employment and utilization of productive resources. However, maximization of economic growth per se and at all costs is not the objective of monetary policy in an Islamic economy. Material prosperity is to be attained within the framework of Islamic values. It should not be attained through the production of essential and morally - questionable goods and services. It should not lead to an excessive and overly-rapid use of Allah-given resources at the expense of future generations, and it should not be harmful to present or future generations by degenerating the moral and physical environment.  Environmental degeneration with degradation and depletion of land, water and forest resources and serious air and water pollution are already matters of great concern around the world. Hence the concept of �sustainable development", which means meeting the needs of the present generation without compromising the needs of future generations. Economic development and sound environmental management are complementary aspects of the same agenda. Without adequate environmental protection, development will be undermined; without development, environmental protection will fail.

Distributive Justice
Monetary policy should be used actively to promote the goal of distributive justice and prevent concentration of wealth and economic power in an Islamic economy. However, too much concern with distributive justice in formulating and implementing monetary policy may adversely affect its overall efficiency and effectiveness in attaining the other goals of monetary policy. e.g. growth, employment and development. Reduction in income inequalities and necessary redistribution should be an important policy objective of an Islamic state and hence the domain, mainly, of its fiscal policy. Monetary policy can contribute to this objective.

Pivot of the Islamic banking System: The central bank should be the pivot of the Islamic Banking System, because only through its conscientious and creative efforts and eternal vigilance can the Islamic money and banking system function properly and achieve its objectives. It should be an autonomous government institution responsible for the realization of the socio-economic goals of the Islamic economy in the sphere of money and banking.

Issue of Currency: Like all central banks, the central bank in an Islamic economy should be responsible for the issue of currency and, in coordination with the government, for its internal and external stability. It should act as banker to the government and the member banks. It should make arrangements for clearance and settlement of checks and for transfers, and should act as the lender of last resort. It should guide, supervise and regulate the commercial banks, the non-bank and specialized financial institutions, without unduly affecting their autonomy. Unlike the conventional central bank, it should also bear the responsibility of preventing the concentration of wealth and power through the financial institutions.

Stabilization of the Value of Money: Stabilization of the real value of money should be an important function of the central bank in order to realize the healthy sustainable growth of the Islamic economy and to ensure socio-economic justice. For this purpose, it would have to keep a close watch on money supply, to ensure that the growth in money is not out of step with that in real output. This does not imply that the money supply is the only variable influencing prices. All it implies is that the money supply matters, and that without its proper regulation one of the important instruments for realizing the economic goals of Islam will have been blunted.

Implementation of Monetary Policy: The central bank should be the primary institution responsible for implementing the country's monetary policy.  For this purpose, it should use the instruments and methods that are not in conflict with the teachings of the Islamic Shariah. Further, since the central bank cannot realize the goal of monetary stability without cooperation from the government, a harmonious fiscal - budgetary policy would be indispensable.

Promotion, Regulation and Supervision: The central bank will also have to play a positive role in the promotion, regulation and supervision of all financial institutions with the objective of helping them and making them healthy and strong. For this purpose it may have to review all existing laws and amend or reconstitute them in the light of Islamic teachings. The reformed banking legislation should reflect the different needs of the Islamic financial system.

Ensure health and Development of Public Interest: The central bank should not confine its regulatory role merely to the commercial banks. Its vigilance and assistance must envelop all other financial institutions to ensure their health and development and to safeguard the public interest. If some other government agencies are responsible for promoting and regulating non-bank financial and auxiliary institutions, then there should be proper coordination between the Central bank and other regulatory authorities to bring on harmony in their promotional and regulatory functions.

Lender of the Last Resort:  As in conventional banking, the Islamic central bank would also have to act as the lender of last resort to ensure sufficient liquidity and to sustain the banks in case of liquidity or solvency crisis. Its ingenuity would be reflected in the way it handled crisis situations without bailing out bank management and yet safeguarding the interest of depositors and equity-holders who are not a part of the management. Temporary accommodation from the central bank provides the borrowing bank with a brief respite and enables it to survive until remedial measures are enforced and become effective. This is necessary for maintaining confidence in the banking system.

Financial Assistance by the Central Banks: The central bank, to help any Islamic bank tide over its temporary liquidity problem, may provide general accommodation in the form of Mudaraba deposit on which the Islamic bank may pay profit at the rate declared on such deposits.

The central bank may also provide refinance to Islamic banks against finance provided by them for purposes, projects or sectors specified by the central bank. Such refinance may be provided under Mudaraba, Musharaka or any other Islamic mode of finance.

Current Account and Clearing House Facility: Islamic banks may be allowed to maintain current accounts with the central bank and to participate in the bank's clearing house operations. If the current account is occasionally overdrawn, the central bank may provide this facility without any charge. Alternatively, such facility may be extended on the basis of sharing of the profits of the bank.

Regulation and Supervision of Islamic Banks: Islamic banks may be subjected to regulations and controls by the Central bank in respect of  (a) permission to establish banks and to open new branches;   (b) minimum share capital;   (c) the terms governing the constitution of Boards of Directors and appointment of Chief Executives and auditors; (d) tariffs for banking services;   (e) measures regulating foreign exchange transactions;  (f) submission of periodical statements and operational data to the central bank  and  (g) Compliance with the working hours.

Inspection of Islamic Banks: Islamic banks may be subjected to periodic inspection by the central bank to ensure their operational soundness. The central bank personnel may be adequately trained in Shariah-based operations of Islamic Banks. Detailed guidelines for inspection of the Islamic banks should be prepared and set by the central bank, as it should carry out research and training of personnel.

Bank supervision and inspection would be more important in an Islamic system. Unlike the examination of conventional banks, it may be necessary to ensure that, in addition to proper documentation, the projects financed dare sound. To examine all projects financed by the banks would be difficult. It should, however, be possible to examine a random sample of projects financed to ensure that banks do not indulge in financing speculative or unduly risky ventures. Supervision should not be concerned solely with individual banks. It should acquire an operational importance and should aim at promoting the efficiency and stability of the whole financial system, by means of action directed towards both the system itself and individual components, without interfering in moral operational decisions. Moreover, supervision presupposes adequate disclosure and accurate information, and proper auditing. The central bank should play an important role in determining the requirements for this purpose. It should try to strengthen internal controls and issue policy guidelines, and monitor the quality of assets and operations. It should reform the concepts and procedures of auditing to ensure soundness and honesty.

To ensure that growth of money supply is adequate and not excessive, it would be necessary and important to monitor carefully all three of the major sources of monetary expansion. The two domestic sources are: i) Financing of government fiscal/budgetary deficits by borrowing from the Central bank; and ii) Expansion of deposits through commercial bank credit creation. The third source of monetary growth is external and is monetization of a balance of payments surplus.

i) Fiscal Deficits - Fiscal deficits can be, and have been, an important source of excessive monetary expansion. Attempts by the government to extract real resources at a faster rate than is sustainable at a stable price level could lead to continually rising fiscal deficits and accelerated increases in money supply, thus contributing to an inflationary spiral. This has tended to shift a disproportionate burden of the fight against inflation onto the monetary policy. According to one important study, "the greater the dependence of the public sector on the banking system, the harder it is for the central bank to pursue a consistent monetary policy". Hence for the monetary policy to be effective, there must be coordination between monetary and fiscal policies for the realization of national goals. This under scores the need for a realistic and non-inflationary fiscal policy in a Muslim country. This does not necessarily rule out fiscal deficits but imposes the constraint that deficits be allowed only to the extent necessary to achieve sustainable long-run growth and broad-based well-being within the framework of stable prices.

The need to eliminate unproductive and wasteful spending is a religious imperative for all Muslims. It is particularly important for governments because they use resources provided by the people as a trust, and using these wastefully or unproductively is a breach of this trust. The limited resources must be used efficiently and effectively with the acute consciousness of accountability to Allah. It requires a careful review of the entire expenditure program in the light of Islamic teachings.

After all the wasteful and unnecessary spending has been eliminated, the balance of government spending may be divided into three parts:

1.       normal recurring expenditures

2.       project expenditures

3.       emergency expenditures

All normal, recurring government expenditures, including outlays on projects not amenable to profit-and-loss sharing arrangements, must be financed by tax revenues. The non-availability of debt financing for such purposes should prove to be a hidden blessing and help introduce the needed discipline in government spending. The government may undertake projects, which are amenable to equity financing, where this is necessary in the public interest, but the financing should be obtained by selling shares to financial institutions and the public. A commercially oriented pricing system should be adopted without a general subsidy.  All subsidies needed for the poor and lower middle class families should be arranged from Zakat revenues, donations or Qard Hasan.  Equity financing and commercial pricing should help eliminate some of the unnecessary and unproductive or prestigious projects that governments sometimes undertake to satisfy vested interests. Emergency expenses or unavoidable deficits, which cannot be financed by either of the two ways may be financed by borrowing from the banking system within a non-inflationary framework and to a limited extent.

ii) Commercial Bank Credit Creation: Commercial bank deposits constitute a significant part of money supply.  These deposits may, for the sake of analysis, be divided into two parts

'primary deposits', which provide the banking system with the base money (cash-in-tills plus deposits with the central bank); and

'derivative deposits' which, in a proportional reserve system, represent money created by commercial banks in the process of credit expansion and constitute a major source of monetary expansion.

Since derivative deposits lead to an increase in money supply in the same manner as currency issued by the government or the central bank, and since this expansion, just like government deficits, has the potential of being inflationary in the absence of an offsetting growth in output, the expansion in derivative deposits must be regulated if the desired monetary growth is to be achieved. This could be accomplished by regulating the availability of base money to the commercial banks.

iii) Balance of Payments Surplus: Only a few Muslim countries have enjoyed a balance of payments surplus in recent years, while most of them have experienced deficits. In the few that did have a surplus, the surplus did not originate in the private sector and did not lead to an automatic expansion in money supply. It did so only to the extent government monetised the surplus by spending it domestically and the private sector balance of payments deficit did not offset this adequately. In the Muslim countries that have a balance of payment deficit, it is unhealthy monetary expansion along with public and private sector conspicuous consumption that generate the balance of payments disequilibrium through current account deficits and underground capital outflows. These cannot be removed without socio-economic reform at a deeper level and healthy monetary and fiscal policies in the light of Islamic teachings.

To realize the objectives of monetary policy in an Islamic framework, the central bank in an Islamic economy may use the following instruments, jointly or separately, for regulation of money and credit:

1. Target Growth in Money Supply: The central bank should determine annually the growth desired in the money supply (M) in the light of national economic goals, including the desired but sustainable rate of economic growth and the stability in the value of money. This target growth in M should be reviewed quarterly, or as often as necessary, in the light of the performance of the economy and the trend of important variables. However, the targets should not be changed frequently but only when justified to accommodate economic shocks, both domestic and external.
2. Statutory Reserve Requirements: Statutory Reserve requirements against the commercial banks' deposit liabilities usually consist of two parts: (a) Compulsory Cash Reserve Ratio (CRR), and  (b) Liquidity Ratio (LR). Commercial banks may be required to deposit with the central bank in cash as CRR a certain proportion, say 5-10 percent, of their total deposits from the public. In addition, the banks may be required to keep with themselves shortly maturing liquid assets, say 10-15 percent, against their deposits. These reserves serve the twin purpose of security and control of the banks' capacity to create credit. Reserve requirements against demand deposits may be higher, while requirements against savings and Term (Mudaraba) deposits may be lower because of their equity nature, meant for investment by the banks and not supposed to be withdrawn frequently. The statutory reserve requirements may be varied by the central bank according to the dictates of monetary policy.
3. Credit Ceilings:  It may be desirable to fix ceilings on commercial bank credit to ensure that total credit creation is consistent with monetary targets. Ins the allocation of this ceiling among individual commercial banks, appropriate care should be taken to ensure that it does not harm healthy competition among banks.
4. Allocation of Credit: Since bank credit comes out of funds belonging to the public, it should be so allocated that it helps to realize general social welfare. The criteria for its allocation, as for other Allah given resources, should be, first, the realization of the goals of the Islamic society, and, second, the maximization of private profit. This could be attained by ensuring that (a) credit allocation leads to an optimum production and distribution of goods and services needed by the majority of the society, and (b) the benefit of credit goes to an optimum number of businesses in society.
5. Selective Credit Control:  In addition to the general qualitative controls, the central bank may use qualitative or selective credit controls to ensure the flow of credit to the desired direction, purpose and extent.  For example, central bank Mudaraba financing may not be made available except for specific purposes. The Central bank may also accept a relatively lower profit-sharing ratio, if considered necessary, for realizing the objective of distributing commercial bank financing to an optimum number of businesses for production of the goods and services, which are most needed.
6. Moral Suasion: Moral suasion or persuasion should acquire an important place in Islamic central banking. The central bank through its personal contracts, consultations and meetings with the banks could keep itself abreast of the strengths and problems of banks and suggest to them measures to overcome difficulties and achieve the desired goals.
7. Other Instruments: For proper functioning of the monetary and credit system and to secure its objectives and mandate the Islamic central bank may also use the following instruments to replace the Bank Rate or Discount Rate and control through regulation of interest rates:
    
   1. Fixing a minimum and/ or maximum ratio of profit for Islamic banks in their joint venture and Mudaraba activities.  These ratios may vary for different fields of activity.
   2. Designation of various fields for investment and partnership within the framework of the approved economic policies, and the fixing of a minimum prospective rate of profit for the various investment and partnership projects. The minimum prospective rate of profit may vary with respect to different branches of activity.
   3. Fixing a minimum and maximum margin of profit, as a proportion to the cost price of the goods transacted, for banks in installment and hire purchase transactions.
   4. Determination of types and the minimum and maximum accounts of commissions for banking services.
   5. Determination of the types, amounts, minimum and maximum bonuses, and the establishment of guidelines for advertisements by banks.
   6. Determination of the minimum and maximum ratio in joint venture, Mudaraba investment, hire purchase, installment transactions, buying or selling on credit, forward deals with respect to various fields of activity; and also fixing the maximum facility that can be granted to each customer.